The horses are spooked.

With barely a fortnight to go before the Melbourne Cup interest rate decision, there’s a growing body of thought that higher fuel prices could tip the balance within the Reserve Bank’s Martin Place boardroom for another rise.

Petrol prices rose somewhere in the order of 7 per cent in the September quarter and since then, the escalating tensions between Israel and Hamas which is threatening an ever-widening regional flare-up in hostilities, has sent oil prices higher.

It’s now possible that this week’s crucial September quarter inflation data could tick higher, after almost nine months of steady declines and following relatively strong jobs data last week.

Where, just a fortnight ago, there was a growing consensus that interest rates had peaked and would plateau out around current levels for a while, the mood has suddenly reversed.

Bookies now are putting a better-than-even chance that Michele Bullock may fire off her first rate hike just weeks after ascending to the central bank’s throne.

The conventional logic goes something like this: Higher fuel prices feed directly into almost everything that is produced, from tradeable goods to services. That will push up prices and reignite community fears that inflation is here to stay, sparking calls for higher wages. The RBA, and most other central banks, will have little option but to jack up rates even further, to wind back demand, in order to tame inflation.

It’s certainly a compelling argument, particularly given the historical comparisons to the 1970s. But there are no certainties when it comes to monetary policy and for all the similarities to the events of half a century ago — oil prices and the Middle East — there are just as many differences.

Where Phil Lowe had little alternative but to push rates higher, the risks of a policy mistake now are high to extreme, making for a torrid debate around the Martin Place board table on Cup day.

A wide shot of the empty Reserve Bank of Australia boardroom.

There’s a compelling argument for the RBA to hike rates next month, but it comes with plenty of risk.(ABC News: John Gunn)

What are the crucial differences between now and the 70s?

As the RBA boss put it a week ago in her “fireside chat”: “We’ve seen shock after shock after shock.”

The Middle East tragedy now unfolding by the hour on our phone screens is merely the latest in a three-year string of disasters.

COVID-19, the chaotic pandemic recovery and Russia’s invasion of Ukraine along with a vicious and largely unexpected return of inflation have sent Central Banks globally into a spin.

Where the world was side-swiped by a sudden inflation surge with the emergence of OPEC half a century ago following an escalation of military tensions between Israel and its neighbours, the globe now is coming off the back of one of the fastest rate hiking cycles in history.

The full impact of those rate rises has yet to be felt. Even here, where interest rate movements flow far more quickly through to household spending than any other developed economy, the blow has been delayed by the huge increase in fixed mortgage rates doled out during the pandemic.

Still, according to a recent International Monetary Fund study, Australia leads the pack when it comes to household pain as this table below shows.

A column chart with yellow bars showing levels of mortgage stress across first-world countries.

Australia has the highest level of mortgage stress in the world, according to the IMF’s Global Financial Stability Report.(Supplied: International Monetary Fund)

That’s only going to get worse as more households suddenly switch from fixed mortgage rates around 2 per cent to 7 per cent as the roll-off onto variable loans accelerates.

That’s an important distinction that many economists don’t acknowledge. Many simply point to the much higher official rates pushed through by the US Federal Reserve as a rationale that we have much further to go.

After 12 rate hikes in 18 months, household spending power is declining and a significant portion of Australian households are suffering mortgage stress. In that kind of environment, it becomes increasingly difficult for firms to pass on higher costs, which effectively blunts the inflationary impact on consumers.

Absorbing those costs, however, eats into company profits which then puts pressure on business owners to cut costs such as staff.

As AMP Capital chief economist Shane Oliver argues, while higher oil and petrol prices will feed into the September quarter inflation figures due this week, ultimately, they could act as a deflationary force.

Unlike the 1970s and even before the Ukraine invasion, when household finances were strong, he argues that Australian household budgets now are stretched.

The $12 weekly increase in fuel means that “$12 a week less is available for spending elsewhere, which in turn, will likely reduce underlying inflation pressures and add to the risk of recession”.

Petrol prices on a board with blurred traffic driving in front

Shane Oliver from AMP argues higher fuel prices could be deflationary because it forces household budgets to adjust.(ABC News: Luke Bowden)

What to do if the economy is just not co-operating

Ask any central banker and they’ll tell you they have just one weapon: interest rates. That’s not entirely true.

They also are quite adept at threats and they never hesitate to use them in an effort to cajole the economy into action. It’s the central banker’s equivalent of “just wait till your father gets home”.

For months now, and as recently as last week, Michele Bullock let it be known that further rate hikes were a distinct possibility, a threat she’s like to repeat in a speech on Tuesday night and again at an appearance before a Senate Committee on Thursday.

She’s had to. For the economy hasn’t quite reacted to the punishing round of rate hikes as expected.

Who would ever have thought that Australian unemployment would have remained well below 4 per cent after interest rates moved from 0.1 per cent to 4.1 per cent? And that’s despite record levels of immigration.

More concerning for the RBA is the recovery in housing prices. Having taken a punishing hit last year, they’ve stunned all the pundits and now all but recovered their losses. That’s largely because of record levels of immigration.

All of these factors, confusing as they may be, will be in the mix on the first Tuesday in November.

Will higher fuel prices entrench inflation? Or will they kill demand? What happens to the horde of young homeowners who took the plunge into property during the pandemic if we hike rates one more time? And what does that mean for the banking system if defaults rise? Will another rate rise kill inflation, or kill the economy?

The RBA has just one, two at the outside, rate hikes available. Does it gamble it away on race day, or hold out for the New Year and maintain the threats?

We’ll get a better idea after the inflation numbers this week.

Extracted in full from: Why higher fuel prices might stop another interest rate hike from the Reserve Bank on Melbourne Cup day – ABC News